Borrower beware: before you take out a home equity loan, watch for these red flags.December 5, 2002: 10:56 AM EST
By Annelena Lobb, CNN/Money Staff Writer

NEW YORK (CNN/Money) – Rapidly appreciating real estate has been the saving grace in a brutal bear market that's now gone on almost three years. And homeowners have taken notice: they've been tapping those growing pots of gold to cover expenses like home improvements, new cars and college tuition.

In a typical home equity loan, you borrow cash against the equity in your home and repay it over a fixed term. You pay most of your fees and closing costs upfront and choose a fixed or variable interest rate. Sounds simple, right?

It usually is. But some home equity loans harbor dirty little secrets. They trap consumers into paying more than they should and can even force them to foreclose on their homes if they get in over their heads. Remember: All home equity loans put your house on the line since your property is used as collateral. And that's the last thing you want to lose.

Before you sign on the dotted line, make sure you know about these six dirty secrets.

The balloon payment Beware the home equity loan that tempts you with unrealistically low payments. Look carefully at the terms: payments might be that low because borrowers pay only interest each month.

That means you must pay the entire principal -- the amount you borrowed -- at the end of the loan term in one very large lump sum called a balloon payment, according to the Federal Trade Commission (FTC). Ouch.

Negative amortization If you think that's bad, it could be worse. Sometimes, your monthly payments on a home equity loan don't even cover all of the interest you owe, said Margot Saunders, a lawyer at the National Consumer Law Center.

That means interest continues to accrue and the total amount owed rises – even though you're not borrowing any more money.

For example, $20,000 borrowed at 10 percent over five years would require monthly payments of $425 to wipe the balance sheet clean by the end of the term. But say your loan amortizes negatively (meaning you're not covering the full tab), and your monthly payments are $150 apiece. At the end of five years, instead of owing nothing, you've paid $9,000 back, but you owe $21,000. That's because you still owe the principal plus additional interest that has accrued over the term of your loan.

Saunders said this type of predatory lending occurs less frequently with home equity loans today than it did five years ago.

Thanks, but no thanks When it comes time to put your John Hancock on a home equity loan, make sure you recognize every document placed in front of you. If the lender asks you to sign papers that include monthly charges for insurance premiums or other 'services' that weren't mentioned before, that's questionable. The FTC calls it 'credit insurance packing'.

If you refuse to sign an 'extra' document, and the lender objects or says your loan papers will have to be rewritten or reconsidered, walk away.

Prepayment penalties Paying debt early should be a good thing. Watch out for loans that charge steep penalties for 'overpaying' each month and wiping out your debts before your term is up, said Saunders. A predatory penalty might be 10 percent of the amount borrowed or a sum equal to three months' worth of payments.

"Sometimes, consumers aren't allowed to prepay, and that's not fair," said Saunders. "You should always be able to get out of a high-interest loan early."

"Home improvement" loans Dishonest lenders sometimes issue unwitting consumers home equity loans with high rates and fees to finance repairs and home improvements, according to the FTC.

In such scams, a contractor (who works in cahoots with the lender) arranges for work to be done and tells the consumer he knows of a cheap way to finance the project.

"The typical pitch they give you is for good, low-cost financing," Saunders said. But the consumer isn't given documents to sign until after the work begins. Only then does he realize he is being issued a home equity loan, and probably an expensive one. But if he tries to negotiate terms or back out, the contractor threatens to leave the work undone.

You have three days Okay, it's not exactly a dirty secret – it's a legal right. But it's crucial information for anyone who wishes to borrow against their home equity.

If you're borrowing against the equity in your primary residence, you have the right to walk away from that home equity loan if you change your mind for any reason within three days of its issue, according to the Truth in Lending Act.

You must inform the lender of your wish to cancel the loan in writing and within three days of issue. The lender must then cancel its security interest in your home and return all fees to you, including any application and appraisal fees you paid to open the account.